Climate change poses risks to the financial system. Yet our understanding of these risks is still limited. As we explain in a recent paper, central banks and financial regulators could contribute to the development of methodologies and modelling tools for assessing climate-related financial risks. If it becomes clear that these risks are substantial, central banks should consider taking them into account in their operations. Both central banks and financial regulators might also consider supporting a low-carbon transition in a more active way so as to contribute to the reduction of these risks.

What are the climate-related financial risks?

Climate change is likely to increase the severity and frequency of extreme events such as floods, heat waves and hurricanes. These events, combined with the incremental changes in climate, can lead to property damages, lower productivity and severe economic disruptions that could result in financial losses. Such losses could destabilise both the insurance sector and the banking system. These are the so-called physical risks.

But the potential impact of climate change on financial stability moves beyond the physical risks. The transition to a low-carbon economy itself might potentially cause severe disruptions and losses for the companies with business models that rely directly or indirectly on fossil fuels. And this could harm not only the banks that have provided loans to these companies, but also the financial investors that have bought stocks and bonds issued by them. A tightening of energy efficiency standards could also affect broader financial exposures, including mortgage lending. These are the so-called transition risks.

Both the physical and the transition risks are potentially significant for the financial sector. And the financial losses that they might cause could be substantially exacerbated because of the highly interconnected global financial system.